Chapter 12
Deductions Allowed in Figuring Adjusted Gross Income

Adjusted gross income (AGI) is the amount used in figuring the floor for medical expense deductions (17.1), the 10% floor for personal casualty and theft losses (18.11), the 2% floor for miscellaneous itemized deductions (19.1), and the charitable contribution percentage limitations (14.17).

AGI also determines the thresholds for the phaseouts of overall itemized deductions (13.6) and personal exemptions (21.12).

If you follow the instructions and order of the tax return, you will arrive at adjusted gross income automatically. But if you are planning the tax consequences of a transaction in advance of preparing your return, see the explanation of how to figure adjusted gross income (AGI) (12.1).

There is an advantage in being able to claim deductions directly from gross income (“above-the-line”) in arriving at adjusted gross income, since such deductions are allowed even if you claim the standard deduction rather than itemizing deductions on Schedule A of Form 1040. Another advantage of such deductions is that they also reduce state income tax for taxpayers residing in states that compute tax based on federal adjusted gross income. This chapter will explain the deductions that qualify for the direct deduction from gross income.

12.1 Figuring Adjusted Gross Income (AGI)

Adjusted gross income is the difference between gross income in Step 1 and the deductions listed in Step 2. Most of the Step 2 deductions can be claimed only on Form 1040 (12.2).

Step 1. Figure gross income. This is all income received by you from any source, such as wages, salary, tips, gross business income, income from sales and exchanges of property, interest and dividends, rents, royalties, annuities, pensions, etc. But because of exclusions allowed by the tax law, gross income does not include such items as tax-free interest from state or local bonds (4.24), tax-free parsonage allowance (3.13), tax-free insurance proceeds (11.18–11.20), gifts and inheritances (11.4), certain home sale gains (29.1), Social Security benefits that are not subject to tax (34.3), Supplemental Security Income (SSI) (21.5, 34.2), tax-free scholarship grants (33.1), tax-free meals and lodging (3.13), and other tax-free fringe benefits (Chapter 3).

Step 2. Deduct from your 2017 gross income only the following items:

• Repayment of supplemental unemployment benefits required because of receipt of trade readjustment allowances (2.9)
• Forfeiture-of-interest penalties because of premature withdrawals (4.16)
• Capital loss deduction up to $3,000 (5.4)
• IRA contributions (8.4)
• Rent and royalty expenses (9.2)
• Educator expenses (12.2)
• Tuition and fees—but only if Congress extends the deduction to 2017 (12.2)
• 50% of self-employment tax liability (12.2)
• Health savings account (HSA) contributions (12.2)
• Health insurance premiums if self-employed (12.2)
• Jury duty pay turned over to your employer (12.2)
• Performing artist’s qualifying expenses (12.2)
• Reforestation expenses (12.2)
• Reservists’ travel costs (12.2)
• State and local official expenses (12.2)
• Moving expenses (12.3)
• Student loan interest (33.6)
• Alimony payments (37.1)
• Domestic production activities deduction (40.23)
• Business expenses (40.7)
• Net operating losses (40.19)
• Self-employed retirement plan contributions for yourself (41.5)
• Archer MSA contributions (41.13)

Step 3. The difference between Steps 1 and 2 is adjusted gross income.

12.2 Claiming Deductions From Gross Income

Many deductions taken directly from gross income in arriving at adjusted gross income are first claimed on Form 1040 schedules devoted to a specific activity, and then the net gain or loss amount for that activity is entered on Form 1040. This includes business deductions claimed on Schedule C (Chapter 40), capital losses claimed on Schedule D (Chapter 5), and real estate rental expenses claimed on Schedule E (Chapter 9).

Other expenses are entered directly on page 1 of Form 1040 or Form 1040A in figuring adjusted gross income. On Form 1040, these deductions, claimed on Lines 23–36, are referred to as “above-the-line” deductions, as they reduce total (gross) income shown on Line 22 regardless of whether itemized deductions are claimed. On Form 1040A, only a few deductions are allowed in figuring adjusted gross income: traditional IRA deductions, student loan interest, educator expenses and, if extended to 2017 by Congress, tuition and fees.

Educator expenses. If you were a teacher, instructor, counselor, principal, or aide in a private or public elementary or secondary school (kindergarten through grade 12) for at least 900 hours during the school year in 2017, you generally may deduct up to $250 of out-of-pocket costs for books and classroom supplies. Professional development expenses qualify for the deduction, subject to the $250 limit. Eligible supplies include computer equipment (including related software and services), other equipment, and supplementary materials used in the classroom. For courses in health or physical education, supplies must be related to athletics to qualify. Home schooling expenses do not qualify. If you are married filing jointly and you and your spouse both qualify as educators, each of you may deduct up to $250 of your qualified costs, for a $500 maximum on your joint return.

If eligible expenses exceed the $250 limit, the excess may be deductible as a miscellaneous itemized expense on Schedule A of Form 1040 (19.1).

The $250 deduction limit may have to be reduced or eliminated completely if certain tax-free amounts are received during the year. The deduction is reduced by tax-free interest on savings bonds used for tuition (33.4), as well as by tax-free distributions from qualified tuition programs (33.5) and Coverdell education savings accounts (33.12).

For 2018, the deduction limit may be raised above $250 by an inflation adjustment; see the e-Supplement at jklasser.com.

Deduction for tuition and fees expired at the end of 2016. When this book was completed, the deduction for tuition and fees had not been extended to 2017 by Congress, and it was unclear if there would be an extension. See the e-Supplement at jklasser.com for an update.

If there is an extension, you may deduct on Form 8917 up to $4,000 of qualifying college tuition and fees that you paid in 2017 if your MAGI does not exceed $65,000 for single and head of household filers and $130,000 for joint returns. A deduction of up to $2,000 is allowed for single and head of household filers with MAGI exceeding $65,000 but not $80,000 and for joint filers with MAGI exceeding $130,000 but not $160,000 (33.13).

Overnight travel costs of Reservists and National Guard members. Armed Forces Reservists and National Guard members who travel over 100 miles and stay overnight to attend Reserve and Guard meetings may deduct their travel expenses as an above-the-line-deduction to the extent of the Federal Government per diem rate for that locality (35.8).

Expenses of performing artists. If you are a performing artist, you may be able to deduct job expenses from gross income, but only if your income is extremely low. You must have:

1. Two or more employers during the year in the performing arts with at least $200 of earnings from at least two of them.
2. Expenses from acting or other services in the performing arts that exceed 10% of gross income from such work; and
3. Adjusted gross income (before deducting these expenses) that does not exceed $16,000.

If you are married, a joint return must be filed to claim the deduction, unless you lived apart from your spouse during the whole year. The $16,000 adjusted gross income limitation (AGI) applies to your combined incomes. If both spouses are performing artists, the $16,000 adjusted income limit applies to the combined incomes, but each spouse must separately meet the two-employer test and 10% expense test for his or her job expenses to be deductible on the joint return.

Clearly, the $16,500 AGI limit is so low that few taxpayers will qualify for the above-the-line deduction. The $16,500 AGI limit has been in the law since 1986. If you qualify, you report the performing artist expenses on Form 2106 (or Form 2106-EZ where eligible) and enter the total on Line 24 of Form 1040, instead of on Schedule A. If you do not meet the tests, the expenses may be claimed if you itemize on Schedule A, but only as miscellaneous expenses subject to the 2% of AGI floor (19.1).

State and local officials. State and local officials paid on a fee basis may deduct from gross income unreimbursed business expenses.

Health savings account (HSA) deduction. If you are self-employed and have coverage under a high-deductible health plan, are not entitled to Medicare benefits, and are not the dependent of another taxpayer, you generally can deduct contributions to an HSA within the limits discussed in 41.10. If you are an employee, and your employer has contributed less than the applicable limit to an HSA on your behalf, you may contribute the balance and deduct it from gross income (3.2).

Moving expenses. Deductible moving expenses are discussed in this chapter (12.3–12.8).

50% of self-employment tax. After you figure your self-employment tax liability for 2017on Schedule SE, you may deduct 50% of it as an above-the-line deduction(see 45.3–45.4).

Contributions to self-employed SEP, SIMPLE, and qualified plans. See Chapter 41 for details on deducting these retirement plan contributions.

Self-employed health insurance deduction. If you were self-employed with a net profit in 2017, you may deduct from gross income 100% of premiums you paid in 2017 for medical and dental insurance, and qualified (see below) long-term-care insurance, for yourself, your spouse, your dependents, and your children who at the end of the year are under age 27 (whether or not your dependents). The instructions to Line 29 of Form 1040 and IRS Publication 535 (Business Expenses) have worksheets for figuring the self-employed health insurance deduction.

You are treated as self-employed for purposes of the 100% deduction if you are a general partner with net earnings, a limited partner receiving guaranteed payments, or a more-than-2% shareholder in an S corporation from which you received wages.

As a sole proprietor, you may claim the 100% above-the-line deduction whether the policy is purchased in your own name or the name of the business. If you are a more than 2% shareholder-employee of an S corporation, the IRS position is that the S corporation must “establish” the health plan, but the plan can be considered “established” by the S corporation even if you obtain the policy in your own name, so long as (1) the corporation makes the premium payments to the insurance company or the corporation reimburses you for premiums you pay, and (2) the premiums are reported as wages on your Form W-2 and on your tax return. Similarly, if you are a partner, a health plan in your name is considered “established” by the partnership if (1) the partnership pays the premiums or you pay them and are reimbursed by the partnership, and (2) the partnership reports the premiums as guaranteed payments on Schedule K-1 (Form 1065) and you include the payments as income on your tax return.

Medicare premiums qualify for the 100% deduction, since they provide insurance that constitutes medical care. As with other health insurance premiums, premiums paid for Medicare coverage of your spouse, dependents, and children who at the end of the year are under age 27 may be included in the 100% deduction

If you have a qualified long-term-care policy, the 100% deduction applies to the premiums that would be deductible as an itemized deduction under the medical expense rules. This amount depends on the age of each person covered, as shown in 17.15. For example, if in 2017 you paid long-term care premiums for yourself and your spouse, and both of you are age 57 at the end of 2017, premiums of up to $1,530 for each of you are includible in the 100% deduction, assuming the policy is a qualifying long-term care policy (17.15).

Restrictions on the 100% deduction. The 100% deduction may not exceed your net profit from the business under which the health premiums are paid, minus the deductible part of your self-employment tax liability and your deductible contributions to self-employed, SEP, or SIMPLE, and qualified retirement plans.

The 100% health insurance deduction may not be claimed for any month that you were eligible to participate in an employer’s subsidized health plan, including a plan of your spouse’s employer or a plan of the employer of your dependent or child under age 27 at the end of the year. If the deduction would be barred for any month because of such eligibility and you have long-term-care coverage that is not employer subsidized, you may claim the 100% deduction for the portion of the long-term-care premiums that is deductible for your age (17.15).

Are you entitled to the premium tax credit? There is a deduction complication if you are also entitled to the premium tax credit for purchasing health insurance on a government exchange (25.12). The computations are interrelated because the amount of the credit affects the computation of the above-the-line deduction and the credit is based in part on adjusted gross income, which reflects the allowable deduction. Publication 974 (Premium Tax Credit) has worksheets for making the computations. If you or your professional tax preparer use tax preparation software, the software will make the circular computations to figure the deduction and the credit.

Penalty on early savings withdrawals (4.16). If you lost interest because you made an early redemption of a savings certificate, the penalty shown on Form 1099-INT or 1099-OID is an above-the-line deduction.

Alimony paid. You can deduct alimony that you paid to your former spouse provided that he or she reports the payments as taxable income; see Chapter 37.

Traditional IRA contribution. The deductible limits, including the phaseout rules for individuals covered by employer retirement plans, are explained in 8.3–8.4.

Student loan interest. You may be able to deduct interest you pay on a qualified student loan, up to a $2,500 limit, subject to a phaseout based on modified adjusted gross income (33.13).

Domestic production activities deduction. The deduction allowed on Form 8903 is entered on Form 1040 as an above-the-line deduction (40.23–40.25).

Attorney fees in employment discrimination cases. Attorney fees and court costs in actions involving unlawful discrimination claims are deductible on Line 36 of Form 1040 (with the label “UDC”) if they were paid with respect to settlements or judgments occurring after October 22, 2004. The deduction may not exceed the amount included in income as a result of the judgment or settlement (11.7).

Archer MSA contribution. If you are self-employed or employed by a qualifying small business and have high-deductible health coverage, a deduction for contributions to an Archer MSA account may be deductible. The deduction is figured on Form 8853 and then entered on Form 1040 with the label “MSA” (41.13).

Jury duty pay turned over to employer. If you receive your regular pay while on jury duty and turn over your jury duty fees to your employer, report the fees as other income on Line 21 of Form 1040 and claim an offsetting above-the-line deduction on Line 36 of Form 1040; label it “Jury pay.”

Repayment of supplemental unemployment benefits. You may claim a deduction from gross income for the repayment or in some cases a tax credit (2.9). Claim the deduction on Line 36 of Form 1040 and on the adjacent dotted line write the amount and label it “subpay TRA” (trade readjustment allowances).

Reforestation amortization. If you do not have to file Schedule C or F to report income from a timber activity, an amortization deduction for qualifying reforestation expenses may be claimed over an 84-month period; see Code Section 194 for details. On Line 36 of Form 1040, the amortization deduction should be labeled “RFST.”

Costs incurred in obtaining whistleblower award from the IRS. You may claim an above-the-line deduction for costs you incurred, including attorneys’ fees, in connection with obtaining a whistleblower award from the IRS as an informant, up to the amount of the award reported as income. Label the deduction on Line 36 of Form 1040 as “WBF.”

Nontaxable Olympic and Paralympic medals and prize money. Olympic and Paralympic athletes are not taxed on the value of the medals won and prize money received from the U.S. Olympic Committee unless they have adjusted gross income exceeding $1,000,000, or $500,000 if married filing separately (11.1). The prize money and the value of medals won must be reported as “Other income” on Line 21 of Form 1040 even if the athlete qualifies for the exclusion. However, where the exclusion applies, an offsetting deduction may be claimed for the nontaxable amount on Line 36 of Form 1040, with the label “USOC.”

12.3 What Moving Costs Are Deductible?

You may deduct unreimbursed expenses of moving your household goods and traveling to a new job location, provided you meet

• A 50-mile distance test (12.4), and
• A 39-week or 78-week work test for remaining in the new location (12.5–12.6). A deduction may be claimed even if the work test has not been met by the filing due date (12.7).

You may be able to deduct moving costs if you move to take your first full-time job or if you are returning to full-time work after a long period of working part-time or being unemployed; see 12.4.

Members of the Armed Forces do not have to meet the distance and time tests if their move is to a permanent change of station; see the instructions to Form 3903.

If your expenses are reimbursed, you do not have to report the reimbursement, provided your employer reimburses you under an accountable plan (20.31, 12.8).

Allowable expenses. If the distance and work time tests are met, you may claim the following unreimbursed moving expenses as an above-the-line deduction on Line 26 of Form 1040:

1. Traveling costs of yourself and members of your household en route from your old to the new locality. Here, you include the costs of transportation and lodging for yourself and household members while traveling to your new residence. Lodging before departure for one day after the old residence is unusable and lodging for the day of arrival at the new locality are included.

   If you use your own car, you may either deduct your actual costs of gas, oil, and repairs (but not depreciation) during the trip or take a deduction based on the IRS standard mileage rate. For 2017, the IRS standard mileage rate for moving expenses is 17 cents per mile; the rate may change for 2018; see the e-Supplement at jklasser.com. Also add parking fees and tolls. Meal expenses are not a deductible moving expense.

2. The actual cost of moving your personal effects and household goods. This includes the cost of packing, crating, and transporting furniture and household belongings, in-transit storage up to 30 consecutive days, insurance costs for the goods, and the cost of moving a pet or shipping an automobile to your new residence. You may also deduct expenses of moving your personal effects from a place other than your former home, but only up to the estimated cost of such a move from your former home. Also deduct the cost of connecting or disconnecting utilities when moving household appliances. The cost of connecting a telephone in your new home is not deductible.

   In one case, a moving expense deduction was allowed for the cost of shipping a sailboat. The IRS had disallowed the deduction, claiming the sailboat was not a “personal effect.” The Tax Court, however, allowed the deduction based on these facts: the couple were active sailors and frequently used the boat; they lived on the sailboat for two weeks immediately before they moved and also for nine weeks after they arrived in the new location; and they kept on board personal effects such as a refrigerator, kitchen utensils, and chairs. According to the court, the boat was so “intimately related” to their lifestyle that it should be considered a deductible personal effect.

If you have to pay a fee to get out of your apartment lease when you move, the fee is not a deductible moving expense. If part of your apartment was a qualifying home office, you may be able to claim an allocable part of the lease cancellation fee as a home office deduction; see 19.14 and 40.12.

Delay in moving to new job location. You may delay moving to the area of a new job location. A delay of up to one year does not jeopardize a deduction for moving expenses. Furthermore, if you move to the new job area within one year, your family may stay in the old residence for a longer period. Their later moving expenses will generally be deductible, even though incurred after one year. For example, the IRS allowed a moving expense deduction to a husband who immediately moved to a new job location, although his wife and children did not join him until 30 months after he began the new job. They delayed so that the children could complete their education. The IRS held that since part of the moving expenses were incurred within one year, the moving expenses incurred later were also deductible.

Moving overseas. If you take a new job overseas and qualify for the foreign earned income exclusion, moving expenses allocable to the excluded income are not deductible (36.6).

Members of the Armed Forces. Members of the Armed Forces on active duty who move due to a permanent change of station can deduct their unreimbursed moving costs without regard to the distance test or the time test.

Retirees or survivors moving back to the U.S. Individuals who move back to the United States after retiring may deduct their moving costs, as can survivors of individuals who were working outside the U.S. when they died. The new home in the U.S. is treated as a new job location for purposes of the distance test (12.4); the 39/78-week time test (12.5-12.6) does not apply.

Nondeductible expenses. Meal expenses while traveling to your new residence are not deductible.

You may not deduct the cost of pre-move house-hunting trips, temporary living expenses, or expenses of selling, purchasing, or leasing the old or new residence, such as attorneys’ fees, real estate fees, mortgage penalties, expenses for trips to sell your old house, a loss on the sale of the house, or costs of settling an unexpired lease. If you have to pay a fee to get out of your apartment lease when you move, the fee is not a deductible moving expense. If part of your apartment was a qualifying home office, you may be able to claim an allocable part of the lease cancellation fee as a home office deduction; see 19.14 and 40.12.

Other nondeductible costs include the cost of travel incurred for a maid, nurse, chauffeur, or similar domestic help (unless the person is also your dependent), the cost of transporting furniture that you purchased en route from your old home, expenses of refitting rugs and drapes, forfeited tuition, car tags or driver’s license for the state you move to, or forfeited club membership fees.

Note: If your employer reimburses you for such nondeductible costs, the amount of the reimbursement is treated as additional pay on Form W-2 (12.8).

12.4 The Distance Test

The distance between your new job location and your former home must be at least 50 miles more than the distance between your old job location and your former home. For this purpose, your home may be a house, apartment, trailer, or even a houseboat, but not a seasonal residence such as a summer cottage. Self-employed individuals are also subject to the mileage test.

In applying the distance test, take into account the shortest of the most commonly traveled routes in measuring the distance between your old home and the new and old job locations. The location of your new home is not considered in applying the test; only the location of your old home is taken into account.

Your job location is where you spend most of your working time. If you work at various locations, the job location is where you report to work. If you work for several employers on a short-term basis and get jobs through a union hall system, the union hall is considered your job location.

First job or returning to full-time work. If you had no previous job or are returning to full-time work after a long period of unemployment or part-time work, your new job location must be at least 50 miles from your former home to meet the distance test.

12.5 The 39-Week Test for Employees

In addition to meeting the distance test (12.4), you must work in the locality of the new job as a full-time employee for at least 39 weeks during the 12-month period immediately following your arrival at the new job location. You do not need to have a job prior to your arrival at the new location. Your family does not have to arrive with you. The 39 weeks of work need not be consecutive or with the same employer. You may change jobs provided you remain in the same general commuting area for 39 weeks. The 39-week test does not apply to employees who become disabled and lose their jobs, or who die.

If you are temporarily absent from work through no fault of your own, due to illness, strikes, shutouts, layoffs, or natural disasters, your temporary absence counts toward the 39-week requirement as full-time employment.

Job transfers. The 39-week period is also waived if you are transferred from your new job for your employer’s benefit. However, it must be shown that you could have satisfied the 39-week test except for the transfer.

What if you initiate the transfer? The IRS held in a ruling that the 39-week test is not waived if an employee initiates the transfer, even if the employer approves. An individual was not allowed to deduct the costs of moving across the country to take a government position when, within 39 weeks of taking the position, he applied for and took another government job in another area. The IRS disallowed the deduction, although the government reimbursed part of the employee’s moving expenses to the new job post, thereby indicating that it considered the transfer to be in the government’s interest. According to the IRS, the waiver of the 39-week test applies to transfers initiated by employers, not by employees.

Joint returns. On a joint return, either spouse may meet the time test. But the work time of one spouse may not be added to the time of the other spouse.

12.6 The 78-Week Test for the Self-Employed and Partners

In addition to meeting the distance test (12.4), you must work full time in the area of the new business for at least 78 weeks during the 24 months immediately following your arrival, of which at least 39 weeks occur in the first 12 months. The full-time work requirement may prevent semi-retired hobbyists, students, or others who work only a few hours a week in self-employed trades or occupations from claiming the deduction.

You are considered to have obtained employment at a new principal place of work when you have made substantial arrangements to begin such work.

The time test is waived if disability or death prevents compliance.

Change of employee or self-employed status. If you start work at a new location as an employee and then become self-employed before meeting the 39-week employee time test, you must meet the 78-week test. Time spent as an employee is counted along with the time spent self-employed in meeting the test.

If, during the first 12 months, you change from working as a self-employed person to working as an employee, you may qualify under the 39-week employee time test, provided you have 39 weeks of work as an employee. If you do not have 39 weeks as an employee in the first 12 months, you must meet the 78-week test.

Joint returns. Where you file a joint return, you deduct moving expenses if either you or your spouse can satisfy the time test based on individual work records.

12.7 Claiming Deductible Moving Expenses

Qualifying unreimbursed moving expenses (12.3) are deductible on your return whether you claim the standard deduction or itemize deductions. Report your expenses and nontaxable employer reimbursements on Form 3903. Qualifying unreimbursed moving expenses from Form 3903 are then deducted on Form 1040, Line 26, as an adjustment to gross income.

Claiming the deduction before meeting the time test. You may deduct your unreimbursed moving expenses even if the 39-week (12.5) or 78-week (12.6) work test has not yet been met by the due date for filing your tax return. If you subsequently fail to complete the work requirement, you have to file an amended return or report income; see the Example below. If you file your return without taking the deduction, you may file an amended return after meeting the time test to claim the deduction for the year the expenses were incurred.

12.8 Reimbursements of Moving Expenses

If your employer reimburses you for deductible moving expenses (12.3) under an accountable plan, the reimbursement should not be reported as salary or wage income on Form W-2 and those expenses are not deductible. The requirements for an accountable plan are similar to those for business travel expenses (20.31).

Qualified moving expenses an employer pays to a third party, such as to a moving company, are not reported on Form W-2.

A reimbursement for expenses that do not qualify for a deduction, such as pre-move house-hunting costs, temporary living expenses, meal costs, or real estate expenses, is reported as compensation on your Form W-2.

On Form 3903, you report your deductible expenses in excess of nontaxable reimbursements, and enter the deductible amount on Form 1040, Line 26, as an adjustment to gross income.

If you had deductible moving expenses in 2017 that your employer will not reimburse (under an accountable plan) until 2018, you may claim the deduction on your 2017 return but if you do, the reimbursement received in 2018 will have to be reported as other income (Line 21 of Form 1040 for 2018). Alternatively, you may wait until 2018, and if your 2017 expenses exceed the nontaxable reimbursement received in 2018, deduct the excess on your 2018 return.